After the May FOMC meeting, when the Fed raised rates by 50 basis points, Chairman Jerome Powell said:
“So 75 basis point increase is not something the committee is actively considering.”
I explained that bit of “Fed-speak” meant…
“75 bps is not on the table… until it’s on the table.”
Looks like it’s on the table.
So the FOMC came out of its June meeting and bumped rates by 75 basis points (or three-quarters of a percent).
It was the biggest hike since Seinfeld and ER dominated prime time. And it was all because inflation wouldn’t comply with their previous demand that it go away.
Let’s not over-complicate things: There are two things that go into the price of anything. Supply and demand. How much people need to buy (and how badly they need to buy it) versus how much of it is available.
Today, inflation is just that simple.
You can plug in all the Harvard PhD formulas around it you want, but none of them will change that simple fact.
Over the past 30- to 40-some years, inflation was largely a Fed-induced monetary phenomenon. Too easy on the monetary reins and the economy gets a little overheated. During those bouts of rising prices, economic math might have made some sense.
But not this time.
Let’s take a look at what the Chairman said, and more importantly, what he didn’t say…
So What Did Professor Powell Say?
Per usual, the chairman opened with a round of solidarity…
We at the Fed understand the hardship high inflation is causing. We are strongly committed to bringing inflation back down, and we are moving expeditiously to do so. We have both the tools we need and the resolve it will take to restore price stability on behalf of American families and businesses.
Then he got down to business, confirming what everyone was expecting…
The labor market is extremely tight, and inflation is much too high. Against this backdrop, today the Federal Open Market Committee raised its policy interest rate by 3/4 percentage point and anticipates that ongoing increases in that rate will be appropriate.
The BIG question on everyone’s mind — the question that many of the reporters ask on a regular basis and the question Powell so deftly avoids — is how high rates are going to go? What does the Fed see as an end game for this?
Now it’s true that the Fed really doesn’t have a mathe-magical formula (or any other crystal ball) that will tell them that. Like I said earlier, the inflation we’re seeing today is basically a very simple supply and demand phenomenon and largely beyond the control of the Fed. But if they came out and admitted that, they’d lose whatever credibility they’ve managed to maintain over the past 109 years.
He went on about the economy…
Recent indicators suggest that real GDP growth has picked up this quarter…
However for the longer term, the Fed expectations for the rest of 2022 is down nearly 1% (0.9%) from its March guess. (FWIW: The Atlanta Fed’s GDPNow current calculation of Q2 GDP is expected to be 0.0%. Being a real time calculation, that will change over the coming weeks, but for now it’s not a great harbinger.)
Then he touched on the employment situation:
The labor market has remained extremely tight, with the unemployment rate near a 50-year low, job vacancies at historical highs, and wage growth elevated.
The reality here is that the official unemployment rate (U-3) is basically back to where it was in 2019…
My belief is that calling this level of unemployment historically low while job vacancies are at historical highs means something in the labor force has fundamentally changed in the wake of the pandemic lockdowns. And things won’t be going back to whatever “normal” was. Perhaps because of this, the Fed estimates unemployment will rise to 4.1% into 2024
On the topic of inflation, Powell stated the obvious:
Inflation remains well above our longer-run goal of 2 percent. … Aggregate demand is strong, supply constraints have been larger and longer lasting than anticipated, and price pressures have spread to a broad range of goods and services.
Excuse me if I sound like a broken record, but supply issues are beyond the scope of anything the Fed can do monetarily to manage inflation. Raising rates to drain some liquidity won’t work. They’ll need to raise rates to move demand — and to do that means pushing the economy into a recession.
Still, he suggested that the committee’s expectations were headed in the right direction (my emphasis):
The median projection is 5.2 percent this year and falls to 2.6 percent next year and 2.2 percent in 2024; participants continue to see risks to inflation as weighted to the upside.
When has the risk of inflation ever been weighted to the downside?
But the chairman was ever the optimist, ending on a positive note…
The American economy is very strong and well positioned to handle tighter monetary policy.
(More on that in a second.)
That’s the Fed’s interpretation of the situation. Here’s what he left out…
The Stock Market is Still Way Out of Whack
It’s not the Fed’s business to comment on the stock market. “Price stability and employment” is supposedly their wheelhouse. But it’s a totally undeniable fact that their policies have an outsized impact on the market’s performance. So I think a word on the market would be in order.
There’s an old investing adage that says when the market falls 20% from recent highs, it means you’re in a bear market. According to that thinking, the stock market entered a bear market this past Monday. But that’s not really the case.
Take a look at the S&P 500 in 2021:
That certainly looks like a bull market. But… if you were invested in anything other than index funds, you know that picture’s not entirely accurate.
For the last decade the market’s strength (as represented by the major indices) has been fueled by two things: high-growth momentum stocks — companies for whom cheap capital (low interest rates) is like oxygen. And “Too Big to Fail” tech companies whose massive capitalization has an outsized impact on the index itself.
Good old fashioned value stocks were a quaint relic of investing times gone by.
Well the recent shattering of the 20% bear market threshold has come on the heels of a breakdown in the TBTF market leaders that carried the market higher throughout most of 2021.
Taking them out of the equation, most stocks have been in bear markets for months. Small cap and high-growth momentum stocks topped out and entered bear markets back in February 2021!
I laid it out with examples in a post late last year.
And today, even with the S&P’s 20% dip, the overall picture is still skewed.
The index is priced roughly at 15-times earnings — considerably lower than it was just a few months ago. That excess valuations are finally being taken out of the market should be good news. But it’s not the reality of the situation…
That 15x is based on unrevised (i.e. inflated) earnings estimates.
Walmart and Target are two major retailers who disappointed with their earnings reports this past quarter. They lowered their guidance going forward (more disappointment). A ton of companies, who are still trying to determine how much of their costs they can pass on to consumers, haven’t adjusted their expectations yet. And when those numbers go down — it means a higher P/E on the index over all. So valuations are still questionable.
One other thing to remember: Markets swing from extreme to extreme — overvalued to undervalued — not overvalued to fair value.
Overall, that means more downside as the S&P 500 keeps correcting its overbought situation.
The bottom line is the “growth at any cost” mantra has gone by the wayside for the foreseeable future and investors are beginning to demand to see cash flow. Value is now starting to matter.
My take: I’d like to see the market head down to the highs of October–December 2019. That would effectively take out the effect of the $5 trillion that was pumped into the market and economy as a result of the pandemic. We can see where we really are in the market from there.
And now a word on that other thing Powell said…
“The American economy is very strong…”
It seems the American public would rather their leaders be way wrong than honest. The last politician who was honest was Jimmy Carter (admitting, on TV, a crisis of confidence) and we know what became of his political career (and legacy).
Powell making this statement about the economy’s strength is purely political. He’s not that stupid.
The “official” measure says two consecutive quarters of negative growth constitute a recession. (Of course, you have to actually live through the negative growth before they confirm that you’re in one.) By that definition, things are still OK.
But you and most regular investors/consumers are smarter than that. You already know we’re well into a recession (or possibly something worse).
Consumer inflation is up nearly 9% year over year…
Producer prices are up nearly 11%…
Average earnings are struggling to keep pace, up only 5.2% over the same period…
While employment costs are soaring too — the highest growth in some 25 years…
There are shortages everywhere thanks to a still-broken supply chain…
Soaring energy prices + food inflation + inflation everywhere else + declining real wages… How can this lead to anything but recession?
It’s around the corner — if we’re not already in it — and in my opinion it won’t be a “soft landing.” Personally, I think the resulting dip in the economy will be felt as moderate to severe.
But there is a silver lining in all this that the eternal optimist Chairman Powell would never dare say to the press…
The coming recession will be the one thing that finally breaks inflation’s back!
Make the trend your friend,
Editor, Streetlight Confidential